GLOBAL INTEREST RATES: DISLOCATIONS AND OPPORTUNITIES

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1 GLOBAL INTEREST RATES: DISLOCATIONS AND OPPORTUNITIES Lin Yang, Dell Francesco Tonin, Bloomberg APRIL // 3 // 2017

2 JAPANIFICATION OF TREASURIES 2 Dislocations in the relation between US rates and Japanese rates has eliminated the appeal for Japanese investors willing to purchase US debt and synthetically turn it into Japanese cash flows

3 TO A US INVESTOR, JAPANESE T-BILLS YIELD MORE THAN US T-BILLS 3 A US investor can purchase Japanese T-Bills and swap all the cash flows into dollar cash flows, thus achieving a yield of 1.22% which is higher than US T- Bills

4 TO A EUR INVESTOR, ANY YIELD PICK UP IS BETTER THAN NOTHING 4 Euro investors starved for yield have turned to USD debt but of recent the yield pick up has dwindled to zero

5 ORIGINS OF THE DISLOCATION 5 The cross currency basis is responsible for the black magic involved in those arbitrage trades

6 DEFINITION OF THE CROSS CURRENCY BASIS 6 The definition of the basis is based on a floating-floating cross currency swap. 3M EURIBOR BANK Corporation or Asset Manager 3M USD LIBOR + Basis

7 NUMERICAL DETAILS ABOUT THE BASIS 7 In this example, EURIBOR flat for 5 years can be exchanged for USD Libor plus 46 basis points

8 UNDERLYING CROSS CURRENCY FLOAT-TO-FLOAT SWAP We show here the details of the underlying cross currency float-to-float swap that defines the notion of the basis. Notice that the swap is floating in both legs, so it needs to be overlaid with a domestic fix-to-floating interest rate swap in most practical applications. This makes the meaning of the sign in the basis counterintuitive 8

9 UNDERLYING CROSS CURRENCY FLOAT-TO-FLOAT SWAP These are the cash flows of the five year swap, shown in USD and in EUR. The forward rate is used to translate from one currency to another. We notice that there is a balloon payment at the end, and the ratio between the USD balloon payment and the euro balloon payment equals the forward rate at trade date. 9 Last date balloon payment exchanged at the forward rate

10 MEASURES OF STRESS IN THE FINANCIAL SECTOR 10 The LIBOR-OIS spread, or LOIS, is a measure of fragility in the banking sector

11 THE HISTORICAL ORIGIN OF THE DILEMMA 11 We can easily see how historically the risk of the banking sector was underpriced before the collapse of Lehman Brothers in 2008

12 MAIN CHART THAT TELLS THE WHOLE STORY 12 Here is the chart of the EURUSD 1y cross currency basis. Note the basis is a negative number

13 PRACTICAL IMPLICATION OF THE BASIS 13 To prove our point with an example, let us look at the Covered Interest Rate Parity (CIP) for EURUSD. In this case we calculate the forward points using the USD and EUR interest rates and we discover, in the one-year tenor, an arbitrage of 91 pips.

14 FORENSIC RESEARCH ON THE ARBITRAGE 14 We have a look at the EUR interest rate curve used for the calculation of the forward points: the standard EUR curve used by default in EUR interest rate swaps

15 DISSECTING THE ARBITRAGE 15 We change the curve to EUR vs. USD Basis curve, which takes the cross currency basis into account

16 CHECKING THE ARBITRAGE 16 And now the discrepancy is just 36 pips.

17 HOW TO UNDERSTAND FX EXPOSURES USING SILLY LITTLE DRAWINGS 17 After changing the curve to the Basis curve, the arbitrage is reduced to 35 pips.

18 CROSS CURRENCY BASIS COMPARISON BY COUNTRY 18 We can compare which currencies exhibit the largest level of the basis. Why does Australia have a positive basis?

19 EXPLANATION OF THE BASIS VIA CREDIT ARBITRAGE 19 Corporations will tend to borrow in those currencies whose markets offer the most favorable conditions: in this chart we show the EURUSD basis together with the spread between US corporate spreads and Euro corporate spreads. As the difference increase, US corporates tend to borrow in euros and then need to swap the debt to synthetic USD debt and this increases the basis. Note that this phenomenon has been specific to Europe, due to the uniqueness of the ECB program

20 EXPLANATION OF WHY CORP SPREAD^2 CREATES THE BASIS 20 Bond Investors Coupons on EUR Bond Issued EUR Fixed BANK 1 BANK 2 3M EURIBOR 3M EURIBOR US Corporation 3M USD LIBOR + Basis 3M USD LIBOR BANK 3 USD Fixed

21 REVERSE YANKEE BONDS The ECB bond purchase program drove EUR-denominated corporate bond spreads lower than they US counterparts In response, US corporates have found more cost-effective to issue in euros, and then swap the proceeds back into USD This corresponded to a surge of issuance in euro-denominated corporate bonds since

22 EXPLANATION OF WHY EURO ASSET MANAGERS CONTRIBUTE TO THE BASIS 22 US Bond Coupons on USD Bond Purchased USD Fixed BANK 1 BANK 2 3M USD LIBOR 3M USD LIBOR + Basis European Asset Manager 3M EURIBOR 3M EURIBOR BANK 3 EUR Fixed

23 EXPLANATION OF WHY EUROPEAN BANKS CONTRIBUTE TO THE BASIS 23 US Loan Coupons on USD Loan USD Fixed BANK 1 3M USD LIBOR BANK 2 3M USD LIBOR + Basis 3M Yen LIBOR Japanese Bank 3M Yen LIBOR BANK 3 JPY Fixed JPY Depositors JPY Interest on Deposits

24 THE CARRY TRADE CONTRIBUTES TO EXPLAIN THE BASIS 24 USD Investment Coupons on USD Bond Purchased USD Fixed BANK 1 3M USD LIBOR BANK 2 3M USD LIBOR + Basis 3M Yen LIBOR Carry Trade Player 3M Yen LIBOR BANK 3 Yen Fixed JPY Liability Yen Interest on Borrowed Money

25 WHERE ARE THE ARBITRAGEURS? Hedge funds, CTA s and all sorts of investors should be able to take advantage of the cross currency basis and should be able to make it disappear But time goes by and the financial crisis recedes more and more in the past and the basis does not show signs of closing This is due to the very reason the basis came to be in the first place: the great financial crisis In order to arbitrage the basis, people have to be able to rent balance sheet from their bank counterparties, the very activity that recent legislation has made so expensive Credit charges, more discriminating Prime Brokerages, margin requirements all conjure to keep the basis alive 25

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